Simply put, your credit is absolutely vital for your financial future. Having a good FICO credit score can save you thousands of dollars down the road, lower interest rates, and overall just make your life easier.
However, there are a number of pitfalls that can set your credit score reeling – even if you aren’t aware of them.
In this article, we will take a look at 7 hidden credit debt credit pitfalls to avoid so you have the most financial leverage.
#1 – Hard Pulls
Whenever you decide to apply for more credit or take out a loan, you may experience what is called a “hard pull”. Each time did you apply for one of these credit applications, you can temporarily lower your credit score – and therefore make it more difficult to obtain favorable interest rates and approval.
Some typical examples of hard pulls include:
- Apartment rental applications
- Auto loan applications
- Credit card applications
- Mortgage applications
- Personal loan applications
- Student loan applications
These instances temporarily drop your credit score by a few points but can last on your credit history for two years. And while the difference between a few credit score points might not be a big concern, imagine that across all of your bills. A 10% increase on these bills due to unfavorable credit scores can drastically detract from your yearly earnings. Even paying $10 more for your car insurance can mean $120 lost annually due to you to applying for credit.
So, what should you do?
First, only apply for credit when you have enough cash in order to pay off more than the minimum payment per month. Second, when applying for a credit card or other payment option, be sure to only do one at a time. Creditors use your credit score as an overview of what type of consumer you are; however, they will look into your recent activity. If it looks like you’ve hit hard times recently, you may be rejected as a potential risk and cash-strapped.
#2 – Credit Utilization
In order to develop a favorable credit score, you need to use credit often and carry a low balance (or pay off bills entirely). This is referred to as “credit utilization”, the ratio of your outstanding credit card balances to your credit card limits.
To calculate your credit utilization ratio,
- divide your credit card balance by your credit limit,
- multiply by 100.
For example, if you have $10,000 divided by $2,000 of credit, you would have a favorable 1:5 ratio. By contrast, if you had $8000 of your $10,000 credit limit, you would have an unfavorable 4:5 ratio. According to most financial experts and hints from most lenders, you want to stay below 20%, a 1:5 ratio.
The lower your credit utilization percentage, the better. A low credit utilization shows that you’re only using a small amount of the credit that’s been loaned to you. However, not using credit also is bad for your credit score. An obvious example of good financial behavior that doesn’t build a credit history and score is for college students turning 18, the legal age to get a credit card. It’s no surprise that college students are often given credit cards with exorbitant APRs and high annual fees.
Last, those who have a poor credit history may rejoice at knowing that most debts are relieved after seven years (excluding student loans). At the same time, inactivity may drop your credit score if you don’t show any credit-building activity, so credit utilization is key.
#3 – Not Understanding Your Credit Score
Having an excellent credit score can lead to low-interest financial opportunities, but do you know what score you have? Here’s how FICO breaks down scores:
- Exceptional: 800 – 859
- Very Good: 740 – 799
- Good: 670 – 739
- Fair: 580 – 669
- Very Poor: 300 – 579
These scores are determined based on the last seven years of your financial performance. The more that you use credit and not miss payments, the greater the score builds – reflecting how lenders see you as a asset or liability.
There are five factors that make up your credit score:
- Payment history (at 35%)
- Level of debt/credit utilization (at 30%)
- The age of credit (at 15%)
- Mix of credit (at 10%)
- Credit inquiries (at 10%)
As you can see, these are graded on a percentage basis. From these percentages, we can ascertain that lenders want those who to lend to individuals who:
- Reliably pay your bills
- Use credit often
- Pay off your credit bills ahead of minimum scheduled payment
- Diversify where you draw credit
- Apply for a new credit infrequently
As you can see, having control of your credit score is of utmost importance. Minimum payments are actually looked down upon, as it conveys to lenders that you choose to take out a loan with interest for the maximum amount of time.
For example, taking out a 20-year mortgage means that you will be charged more up front with less interest than when compared to taking out a 30-year mortgage. If you have other significant loans, such as student loans, and haven’t paid off a substantial amount of the balance, you may find some difficulty finding lenders that are willing to tack on another bill that may or may not be recouped.
Errors on Credit Report
People make mistakes. And when these mistakes are paired with numerous credit reporting agencies with different sources, you can expect that there might be some existing unpaid bills on your credit – even after you’ve squared up the balance.
This may come as a shock, but you will need to periodically check your credit reports from all three major credit bureaus to understand which bills are still deemed outstanding even after paying them off:
The three major credit bureaus offer free reports every 12 months, which gives you the opportunity to check your score every 4 months if you do choose. Or, you can get them all at one and review them for any discrepancies.
If you do discover a debt that you have paid off but is still regarded as outstanding, be sure to immediately get in contact with that company. Often, you’ll have to reach these companies or collection agencies by phone, explain the error, and monitor your credit report until it is resolved. This can be a lengthy process, but clearing your name of any financial wrongdoing will give you a significant boost to your credit score.
Not Paying Off Credit Cards in Full
Charging interest for a line of credit is how financial institutions make money. However, if you pay off your credit card statement balance in full by the due date (or beforehand), you won’t have to pay any interest.
This may seem obvious, but paying minimum payments benefits the lender, not the credit card holder. Over the course of making minimum payments, you will be charged interest at the annual percentage rate, or APR.
Because it’s not uncommon to see credit cards that charge APR around 25%, card holders need to be aware of how important it is to pay what they can when they can. If minimum payments carry-on for years, you could easily end up paying several times over for an item’s initial value.
Late or Missed Payments
Building credit is a lot like building trust: it takes years of good behavior to create, but can be eradicated by only a few mistakes.
As you learned before in this article, on-time payments make up 35% of your overall credit score. Simply forgetting to pay a bill on time or coming up short can lead to significant financial drawbacks in the future. That’s why you should make it a priority to pay your bills in a regular fashion – or just set up automatic payments to deduct from your accounts.
If you’re using credit on a regular basis, you should be aware of which fees are associated with each card that you use.
Be on the lookout for fees, as credit cards can charge:
- annual fees
- cash advance fees
- balance transfer fees
- foreign transaction fees
- late payment fees
- returned payment fees
- overbalance fees
- and more
Of those listed fees, you can avoid all of them except for annual fees just by only using credit cards responsibly.
This is where reading the fine print can help you avoid paying more than necessary to have a line of credit. Take the time to understand how rewards cards actually benefit you; you may find that an annual fee offsets any miles or hotel discounts that you earn.